The US stock market’s rally is increasingly splitting along size lines, with small-cap shares losing ground as rising Treasury yields and higher borrowing costs weigh more heavily on companies in the Russell 2000 than on their larger peers.
The Russell 2000 started September up about 20% for the year, comfortably ahead of the S&P 500’s 13% gain and the Nasdaq-100’s 17% advance. The picture has changed sharply this month. The small-cap index is now up about 14% year to date, while the S&P 500 has gained roughly 20% and the Nasdaq-100 about 12%, according to the figures provided.
The reversal comes as the US Treasury market has come under pressure, pushing yields higher and bond prices lower. That impacts smaller companies disproportionately because they tend to have greater exposure to financing costs and less financial capacity to absorb a sustained increase in the cost of capital.
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“Small caps have had a more difficult time adjusting to the Fed’s hawkish turn and continued increase in rates at the long end, evidenced by the fact that their negative correlation to the 10-year Treasury yield is two times that of large caps,” said Kevin Gordon, head of macro research and strategy at the Schwab Center for Financial Research.
The relationship between small-cap stocks and longer-dated government bonds has become unusually strong. The iShares Russell 2000 ETF (IWM) currently has a correlation of 0.51 with the 20+ Year Treasury Bond ETF (TLT), compared with 0.29 for the SPDR S&P 500 ETF Trust (SPY) and 0.1 for the Invesco QQQ Trust.
More strikingly, the correlation between small caps and the price of the 10-year Treasury note reached above 0.97 last week, the highest level in a year. That suggests the recent weakness in smaller companies is being driven less by a deterioration in their underlying businesses and more by a rapid repricing of interest-rate expectations.
For small-cap companies, the transmission mechanism is relatively direct. Smaller businesses generally have less access to cheap financing than large corporations, while many depend more heavily on bank lending and floating-rate debt. Higher yields can therefore increase interest expenses, reduce the present value assigned to future earnings, and make it harder for companies to fund expansion.
Large technology companies have been more insulated from that pressure because many have strong balance sheets, substantial cash holdings and considerable free cash flow. That divergence helps explain why a higher-rate environment can weigh on the Russell 2000 even while the broader S&P 500 continues to advance.
The difference is becoming visible in derivatives markets.
Options activity around IWM suggests investors are positioning for further volatility in small caps. More puts than calls traded in IWM on Thursday, while trading in SPY was close to balanced and calls outnumbered puts in the Nasdaq-100-linked QQQ.
Options volume across the major ETFs was elevated. Trading in SPY and QQQ was about 40% above the 30-day average by midday Thursday, while IWM volume was almost twice its 30-day average. Traders appeared to have purchased about 480,000 IWM puts compared with 371,000 calls. Total open interest in IWM puts stood just below 7 million contracts, compared with about 3 million calls, according to Cboe LiveVol data.
The options market was not uniformly bearish, however. Some investors were selling puts, generating premiums from traders seeking downside protection. That means the elevated put activity does not necessarily represent a straightforward bet that the Russell 2000 will collapse.
Still, the distribution of the most actively traded contracts showed a clear preference for downside protection. The four most popular IWM trades by volume were puts, with the 280- and 281-strike puts expiring Thursday accounting for more than 120,000 trades. The 269-strike put expiring October 16 was the next most actively traded contract. That option would require roughly a 4% decline in IWM before it becomes profitable for its buyer, based on the figures provided.
SpotGamma data also showed the scale of the defensive positioning. Of the $322 million in IWM option premium traded Thursday, roughly $100 million was likely spent buying puts, compared with about $50 million spent buying calls. At the same time, significant put-selling activity meant that more premium was associated with likely put sales than purchases.
The options market is thus signaling concern about downside risk rather than providing a simple forecast of further losses.
Gordon said additional weakness could emerge if rates continue rising, but argued that investors should not overlook improving fundamentals among some smaller companies.
“There is probably some more weakness to come if rates continue to move higher, but from a broader perspective, I wouldn’t discount the still-strong fundamentals that some small caps are showing,” Gordon said.
He pointed to improving purchasing managers’ indexes and US growth data as evidence that the economic backdrop remains supportive. Forward earnings estimates for small-cap companies also remain solid, he said.
That creates an important tension in the current market. The Russell 2000’s weakness does not necessarily mean the US economy is deteriorating. In fact, smaller companies can benefit disproportionately from stronger domestic growth because they tend to generate more of their revenue inside the United States than multinational large caps.
The problem is that stronger economic activity can coexist with higher yields. If robust growth keeps inflation elevated or delays interest-rate cuts, the same economic resilience that supports corporate revenues can also keep financing costs high.
That dynamic leaves small caps particularly exposed to the long end of the Treasury curve.
The market’s recent behavior also illustrates why the Russell 2000 can diverge sharply from the S&P 500 even when both are exposed to the same macroeconomic environment. The S&P 500 has substantial exposure to highly profitable companies with strong balance sheets, while the Russell 2000 contains a much larger share of companies whose valuations and financing structures are more sensitive to changes in borrowing costs.
The result is a market in which the direction of Treasury yields has become an increasingly important determinant of relative performance.
If yields stabilize or begin to fall, the same mechanism could work in reverse. Lower borrowing costs would ease pressure on companies with greater financing needs and potentially increase the attractiveness of smaller stocks after their recent underperformance.
For now, however, the Russell 2000 remains caught between two opposing forces: relatively healthy US economic and earnings expectations on one side, and a bond market that is demanding a higher cost of capital on the other. That leaves the small-cap rally particularly sensitive to what happens next in Treasury yields.
Analysts believe that if rates continue to rise, the recent shift away from small caps could extend. But if yields settle without a significant deterioration in economic growth, investors may have to reassess whether the Russell 2000’s recent underperformance has become disconnected from the underlying earnings outlook.